In a key employee disability policy, where the employer pays the premiums, what is the tax consequence of the benefits paid to the employee?

• A. Benefits are tax-free to the employee
• B. Benefits are fully taxable
• C. Premiums are deductible to the employee
• D. Benefits are not taxable under any circumstances

Answer: (B)

When the employer pays the premiums for a key employee disability policy, the benefits paid to the employee are fully taxable as ordinary income. The reason is that the premiums were funded by the employer as a business expense and not by the employee with after-tax dollars, so the disability benefits essentially replace wage income and are taxed when received.

If the employee had paid the premiums with after-tax dollars, the benefits would generally be tax-free, but that isn’t the situation here. Saying benefits are not taxable under any circumstances isn’t correct, and discussing deductions for the employee doesn’t apply since the employee isn’t paying the premium.